Central banking: The New Era

Rate normalisation is the phrase on everyone’s lips. Well, maybe not everyone’s…some people have just been saying “higher interest rates.” Currently, the United States and the UK look like they going to be the pathfinders, striding toward rate hikes while several other major central banks are tiptoeing forward, and in other cases, are beating a path in the opposite direction.

The Bank of England looks closest to increasing policy rates. Governor Mark Carney rattled global markets in mid-June by commenting that the first rate hike “could happen sooner than markets currently expect.”  Before his speech, the market was pricing roughly a 15% chance of policy tightening this side of Christmas. Now the market is pricing roughly a 75% chance.

The UK certainly looks ready for policy tightening. The unemployment rate has tumbled through the 7% threshold level that, under the Bank of England’s previous forward guidance, would have triggered policy-rate hikes. Economic growth continues to beat expectations, and house prices are once again soaring away –with London now dragging the rest of the country along for the ride. True, wage growth has been disappointingly weak, but survey indicators point to increased tightness in the labour market, so it’s possible that the average weekly earnings data are not accurately reflecting mounting wage pressures. From what I can see, Mark Carney has been in danger of falling behind the curve.

Contrary to some fears, Federal Reserve Chair Janet Yellen last week indicated little inclination to follow Mark Carney’s lead in bringing forward expectations of rate hikes. She downplayed the significance of the recent rise in U.S. inflation and emphasised that the labour market still has a lot of slack. Importantly though, between now and the end of 2015, the question is when will the Fed increase rates, not if. The Fed is moving closer to rate normalisation, possibly lagging the Bank of England by a year at most.

Where the Federal Reserve goes, the Bank of Canada follows and this time is no different. Although inflationary pressures are building, hopes for  rebalancing of the economy from consumer spending to exports mean that the central bank is biased against a premature tightening in monetary conditions (translation: tightening monetary policy before the U.S. central bank) since that could trigger a sharp appreciation of the Canadian dollar and derail the much-hoped-for export-led recovery. As a result, the Bank of Canada looks likely to increase policy rates after – but not long after – the Federal Reserve.

In contrast, the European Central Bank, the Bank of Japan, and the Reserve Bank of Australia have maintained their easing bias. Take the Bank of Japan for instance. They’re currently increasing the monetary base at an annual pace of 60-70 trillion yen via the asset-purchasing program and a loan-support program. There is speculation that there could be more to come later this year – and even if those expectations aren’t fulfilled, there is simply no discussion of a tightening in monetary policy for the foreseeable future.

The Reserve Bank of Australia has been maintaining a neutral policy stance – but a note of uncertainty and concern has been creeping into their commentary: “low interest rates were working to support demand, although it was difficult to judge the extent to which this would offset the expected substantial decline in mining investment and the effect of planned fiscal consolidation.” If there’s going to be a move in rates this year, it’s more likely to be down than up.

Finally, in the case of the ECB, their easing bias has been strengthened significantly. On 5th June, ECB head Draghi cut the official policy rate to 0.15% and lowered the deposit rate into negative territory. The policy rate cuts were further complemented with renewed forward guidance on interest rates, as well as a series of aggressive credit easing measures aimed at increasing lending. He also hinted that the ECB wasn’t yet finished; they’ll intensify preparation for direct purchases of asset-backed securities. Just as the Fed and the BoE are gearing up to remove monetary stimulus, the ECB has unleashed some of its most powerful tools yet.

True, all these central banks share one key common factor. “Normal” rates still remain a distant prospect. But a look back at policy rates since 2004 shows the significance of what lies ahead. For the past decade, with the exception of the RBA, major central bank policy rates have generally been moving in the same direction – rising during the period 2005 to 2008, before plummeting in 2009 and then largely staying untouched since then. The divergence in the direction of major central banks that is set to take place could herald a new era for markets….

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